Capital Structure and Excess Returns across Business Cycles

Sammanfattning: In this study, we analyze the leverage-return relationship in a sample of S&P 500 firms in the US between 1969Q4 to 2015Q2 and distinctly examine how the relation changes between business cycles. Our empirical results suggest that an increase in leverage is positively related to expected excess return across business cycles, with a stronger effect in contractions. We attribute the strengthened effect on excess return observed in contractions to negative financial shocks associated to changing macroeconomic conditions which increases the risk associated with leverage. Additionally, we conduct an analysis on average excess returns based on leverage deciles. The relation is indistinguishable between all cycles and negative in periods of contraction and expansion alone. The finding is important as it suggests that leverage in isolation has insufficiently explanatory value to expected excess returns on a subsequent quarterly average basis.